For Bond Investors: Pick the Ugly Ducklings

By ROBERT D. HERSHEY Jr.

Published: January 23, 2000

It seems almost preposterous to contend that the bond market could be a rewarding place to be this year. Not after turning in its second-worst performance in a quarter century during 1999 -- negative returns at that -- as stocks, to rub it in, produced yet another year of double-digit gains.

And not when an unusually strong professional consensus agrees that the three-quarters of a percentage point that the Federal Reserve has raised short-term interest rates since last summer gets it just halfway to its likely goal.

As rates rise, of course, prices fall. The math is ironclad. And piling into a money market fund is not an unreasonable course of action today.

Yet one does not have to be a knee-jerk contrarian to see grounds for hope. For one thing, the bond market has almost never gone south two years in a row. More importantly, some believe the impending rise in rates seems likely to peak by mid-year, leading to what might be a substantial rally.

And if stocks falter in the meantime, bonds could get better sooner by attracting scared equities money.

''We're back in action as an alternative to the wonderful world of equities,'' Jack Malvey, chief global bond strategist for Lehman Brothers, predicted.

The way to play this prospect, according to Marilyn Cohen, a Los Angeles adviser who specializes in bonds for individuals, is to start accumulating these ugly ducklings now, but keeping maturities short. With two-year and five-year United States Treasuries yielding 6.45 percent and 6.63 percent, resepctively, nearly as much as the 6.70 percent offered for those coming due in 30 years, there is little incentive to risk buying the longer, more volatile maturities.

''I'd start nibbling right away,'' said Ms. Cohen, who heads her own firm, Envision Capital. The idea is to gradually feed in additional money as rates rise, not worrying about catching the yield peak, which few are lucky enough to do anyway.

''You're never rewarded in the good markets unless you are venturesome and take a position in the bad markets,'' Ms. Cohen said to justify a strategy, sound as it is, that risks being a bit early.

The assumption is that the Fed's tightening will, in fact, be successful in cooling the economy, which will curb demand for capital and allow rates to subside.

That's when investors shovel in the rest of their stake, moving out to more distant maturities. Keep in mind, though, that there is no clear signal. The cooling may come earlier or later than expected and the market may judge this well or poorly.

For all investors know, the current dip of 30-year rates below 10-year rates, for example, may mean investors are already expressing confidence that the Federal Reserve will succeed in keeping inflation at bay. When everybody expects the long bond to get to 7 percent, that's a reason for it not to happen.

So which bonds to buy?

Treasuries, which are extremely marketable, carry no risk of default and are not taxable by state and local governments, are preferred by many.